Monday, March 28, 2011

Who are Japan's ruling class? Japan's bureaucracy rules the country. The bureaucrats are a remarkably stable class. At certain age they retire into senior positions in companies like Tokyo Electric that owns the nuclear plant in crisis, a practice called amakudari.

In theory, Japan's bureaucrats are the best and the brightest in the country. The senior people in the bureaucracy are almost all graduates of Tokyo University. Their superiority over the population was unquestioned for a long time and remains extremely high. However the record is not there to back up their prestige.

Japan's post-WW II recovery was often attributed to this ruling class, personified in the MITI's planning. The evidences are quite mixed on the MITI's record. The buildup of infrastructure was important to the country's development. But, anybody would know its importance. You don't need to go to Tokyo University to know the importance of infrastructure. In terms of industry planning the MITI-led bureaucracy probably didn't contribute at all. When Honda wanted to make cars in addition to motorcycles, MITI was against it. It led the country into heavy industries that still burden the country.

In the past two decades, the incompetence of this ruling class is for everyone to see. They led the country dow a massive bubble in the 1980s and couldn't get the country out of its subsequent malaise. Why wouldn't Japanese people overthrow such a ruling class? Japan needs a jasmine revolution.

2011-03-28 / Andy Xie

Summary

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Japan's 9.0 earthquake will increase inflationary pressure in the world through (1) BoJ's monetary expansion, (2) through disrupting the supply chains in automobile and electronics industries, and through increasing demand for fossil fuels. Japanese yen is likely to depreciate substantially this year, which would pressure other Asian currencies too.

In the long run, it discredits the nuclear power industry. No matter how well nuclear power plants are designed, unanticipated events and human errors always remain significant. When a nuclear power plant breaks down, the consequences can be catastrophic and lasting. Despite many government officials' reassurance, China should suspend the country's nuclear power expansion plan indefinitely and shut down the existing plants that are close to population centers.

The global economy will depend on fossil fuels indefinitely. The high prices will keep inflation high for years to come. Cutting consumption through changing lifestyles and development model is the only path forward. For China, in particular, the relentless pursuit of quantity expansion must be stopped immediately.

The power of nature deserves more respect

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Watching the 10 meter tsunami sweeping away houses and cars like matchboxes, one couldn't help but be awed by the power of nature. All the human technologies that science and technology have bought are so insignificant in comparison. At a moment like this one doubts the human confidence in the omnipotence of science and technology.

The catastrophe at the Fukushima Daiichi Nuclear Power Plant reminds us all the folly of human being's overconfidence in man's ability to play with nuclear power. At a moment like this one would be willing to give up ten times the benefits from the plant's power generation for the last forty years to avoid this catastrophe.

The consequences for Japan from this disaster are massive and long lasting. Total casualties are likely to rise above 20,000 or 2 out of every ten thousand. The market talks about $200 billion in reconstruction cost and $500 bn in economic loss-reconstruction cost plus lost output. The chances are that the realized figures would be twice as high. More seriously, the fallout from the nuclear disaster will affect food and water supplies for years to come, causing anguish among the people that couldn't be estimated in economic value.

The failure of elitism

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In the aftermath of the disaster the world is impressed by the calm and orderliness of the Japanese population. The exodus of foreign population in Tokyo is in such a contrast with the calmness of local people. Even though the fear of shortage is palpable, Japanese people que up for everything.

In contrast with people's outstanding behavior, Japan's leadership has again demonstrated its incompetence. Japan is such a poorly led country. Much of the country's long decline could be blamed on this. When such incompetence is applied to a nuclear situation, the consequences could bring an end to a country.

Who are Japan's ruling class? The world observes frequent changes of Japan's government. It leaves an impression of instability. In reality, Japan's bureaucracy rules the country. The bureaucrats are a remarkably stable class. At certain age they retire into senior positions in companies like Tokyo Electric that owns the nuclear plant in crisis, a practice called amakudari.

In theory, Japan's bureaucrats are the best and the brightest in the country. The senior people in the bureaucracy are almost all graduates of Tokyo University. Their superiority over the population was unquestioned for a long time and remains extremely high. However the record is not there to back up their prestige.

Japan's post-WW II recovery was often attributed to this ruling class, personified in the MITI's planning. The evidences are quite mixed on the MITI's record. The buildup of infrastructure was important to the country's development. But, anybody would know its importance. You don't need to go to Tokyo University to know the importance of infrastructure. In terms of industry planning the MITI-led bureaucracy probably didn't contribute at all. When Honda wanted to make cars in addition to motorcycles, MITI was against it. It led the country into heavy industries that still burden the country.

In the past two decades, the incompetence of this ruling class is for everyone to see. They led the country dow a massive bubble in the 1980s and couldn't get the country out of its subsequent malaise. Why wouldn't Japanese people overthrow such a ruling class? Japan needs a jasmine revolution.

The bizarre currency market

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One bizarre phenomenon is yen's surge after the earthquake struck. The rationale is that Japanese companies would sell foreign assets to buy yen for reconstruction in the country. Hence, the yen would surge first. This is like buying up all the water near a house on fire. Such a strategy works if the financial market behaves like a monopoly as in ganging up. In the water example, if it is plentiful and worth nothing eventually, when the household owner buys it for fighting the fire, competition will bring the price down to nothing. In the yen case, as the market is so vast, how could it behave like a monopoly? The reason is that interest rates are so low that holding onto the long yen position costs little. Hence, the speculators all have a chance to wait until the last minute, forcing Japanese companies in urgent need of yen to buy.

G-7 intervened in the market to bring down yen's value. Many argue that it is anti market and wouldn't work in the long run. Such crazy arguments have a big audience in the world. The financial market has evolved into an entity for gaming the system for profit. The reason is the liquidity excess. So many people with so much money with little else to do gang up to create games for profiting from clueless or slow people. The origin of the system is central banks' penchant to stimulate by printing money. This practice has led to massive buildup of liquidity in the global financial system. When the system blew up in 2008, governments around the world bailed it out in the name of saving the economy.

When a country loses massive amount of wealth like in Japan's case, ceteris paribus, its currency goes down to reflect its diminished circumstance. The market's story on the short term dynamic wouldn't work out in a rational and competitive market. The Bank of Japan is pumping massive amount of money to support the economy. When the money finally trickles into the real economy, yen will depreciate due to rising supply. When one realizes that, it wouldn't make sense to hoard yen now, even though there would be temporary surge in yen demand in a few weeks due to the repatriation funds by the Japanese corporates. The Bank of Japan could lend yen to Japanese companies temporarily and allows them to swap foreign assets into yen gradually.

I wouldn't be surprised that dollar-yen rate reaches 100 this year. The economic loss is probably equal to Japan's foreign exchange reserves. The disruption to production could dent Japan's exports for months to come. At the same time Japan needs to import much more oil and gas to run the economy, as the nuclear power plants are shut down. The fundamentals for the yen have weakened considerably. The yen value should reflect the new reality.

Another inflation shock

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Japan's earthquake is the third inflation shock in 2011. Australia's floods would significantly affect grain supply. The jasmine revolutions in the Middle East have increased risk premium in oil price and may decrease production in the coming months. Japan's earthquake increases money supply and demand for oil and decreases manufacturing output.

The term 'shock' seems to suggest a transient nature. Could we wait its effect out? The story isn't as simple as that. Inflation is a monetary phenomenon in the long run. How quickly money becomes inflation depends on circumstances. Shocks accelerate the process of turning money into inflation.

The three shocks also delay monetary tightening and increase money supply in some cases. The BoJ will likely monetize a big chunk of the reconstruction cost. The government of Japan has 225% of GDP in debt. The market may not have the capacity to absorb a massive increase in JGB supply. The BoJ has to absorb quite a bit to stabilize the JGB market. If JGB interest rate rises, the interest rate cost on the national debt will bankrupt the government. Hence, the BoJ has to keep the JGB interest rate low through its purchases.

When the BoJ holds down JGB interest rate through its purchases, this action will manifest itself in the market through yen devaluation. The yen needs to devalue quickly and big and appreciates gradually afterwards. The JGB investors wouldn't have time to react when yen drops and, afterwards, have not incentive to sell as yen appreciation would compensate for the low interest rate.

Yen will devalue quickly and appreciate slowly in the future, in contrast to the past pattern of appreciating quickly and depreciating slowly. I wouldn't be surprised that the dollar-yen rate rises suddenly to 100 in the second half of 2011. The inflation shocks eventually change the market's expectation on the Fed's interest rate policy. When it happens, the dollar-yen rate may make such a move.

The death knell for nuclear power

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I have always been a big supporter for nuclear energy on environmental ground and economic efficiency. The developing countries account for 80% of the global population. If they consume as much fossil fuel as the developed countries through economic development, the earth may not be able to sustain it. The consequences are too grave to contemplate. Nuclear power is a lesser evil and, hence, worth trying. The Fukushima incident has changed my mind.

The Fukushima crisis reminds us that human error could bring the world to an end sooner than global warming. It is virtually impossible to eliminate human errors in running nuclear power plants. While many Chinese officials assure people that China's technology is safer, I couldn't stop thinking about unsafe foods, highest traffic accident rate in the world, and widespread quality problems in so many products in China. When I stretch the imagination to the country's nuclear power plants, it terrifies me.

China has suspended the expansion of the nuclear power industry. This is the right thing to do. Indeed, all the existing plants near population centers should be stopped as soon as possible.

The Fukushima incident will change other countries' nuclear programs. Germany has decided to stop renewing the operating life of the existing plants. India and the US are rethinking their expansion programs. The domestic resistance will surely slow or even cancel such programs.

Hence, the global economy will become much more dependent on fossil fuels in the coming years. That means accelerating environmental degradation and rising costs. The solution to the world is consuming less, not looking for alternatives. That means changing lifestyles and development models.

The US, for example, uses most of the energy for cooling and warming up houses and offices and for transportation. If the offices and houses are properly insulated and people all shift to hydride cars, the US's energy consumption can drop by one third or more. You may ask why the US hasn't done so. Behavior changes only if the law changes, culture changes, or price changes. Unfortunately, the first two are not happening. Only price high enough will do the job.

China's development is extremely energy intensive, because it's export and investment-led. China consumes more energy than the US but with 40% as much output. The US is already highly wasteful in energy use. It shows how China's economy is energy dependent. The model is not sustainable. Either the government changes its policy or the market will force the country to change. China's oil exports may exceed the US's in this decade. China will run trade deficits when oil price reaches $200/barrel. The resulting devaluation pressure may bring the country to a halt. It is better to change voluntarily rather than being forced by the market.

Supply chain interruptions

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Global division of labor has become very refined in the past two decades of globalization. Often a product will become components from many countries. Together with greater division of labor the just-in-time management system has become prevalent to save inventory cost. The two combined make the global economy vulnerable to a supply chain shock like Japan's earthquakes. General Motors has already shut down a truck production line for lack of components from Japan.

Japan specializes in many key components in electronics and automobiles. Iphone, for example, depends on Japan's supplies for many of its key components. The similar goes for many machinery products. Japan's supply chain disruption could lead to shortages of many popular products.

As nuclear power accounts for 30% of Japan's electricity supply, its shutdown could affect Japan's manufacturing for a long time to come. Further, radiation could complicate the situation. It is likely to cripple Japan's agro exports. We don't know how other countries will react to manufacturing products with unusually high but not dangerous levels of radiation.

Supply chain interruption is usually short lived. Its inflationary impact will go away quickly. Japan's case is different. The removal of 30% of its electricity supply can make the interruption lasting for many industries. Nuclear contamination worsens the situation. Its inflation impact will last.

Summary

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Japan's earthquake worsens the global inflation crisis. Through its impact on the BoJ's monetary policy it will lead to greater yen supply, yen depreciation, and higher global inflation.

The shutdown of Japan's nuclear power plants will increase Japan's demand for fossil fuels, increasing the pricing pressure in the market.

Japan's nuclear disaster will slow or cripple the development of nuclear power industry around the world. It increases fossil fuel prices in the long term. The only way out is to cut energy demand through changing lifestyles and economic development models.